Money and Inflation

1
Money and Inflation
2
Structure

1. Introduction
2. The Costs and the Origins of Inflation
3. The Phillips-Curve and its Implications
4. Indexation - An International Comparison
5. Conclusion

3
Introduction

• Inflation is a rise in the general price level
  and is reported in rates of change. The inflation
  rate is determined by finding the difference
  between price levels for the current year and the
  previous given year
• ?t ( Pt - Pt-1 ) / Pt-1.
• If Y and V are constant, inflation can only arise
  on the condition of
• ( Mt - Mt-1 ) / Mt-1 gt 0.

4
Introduction

Milton Friedman Born 1912, Nobel
prize in 1976
Inflation is always and everywhere a monetary
phenomenon
5
Introduction
Increase in Inflation and money supply in the
USA (10 years annual average examination)
1910
1970
1940
1980
1960
1950
Growth rate of the Inflation
1900
1890
1930
1870
1880
1920
Growth rate of the money supply in percent
6
Introduction
Different calculations of Inflation
Price index GDP deflator
Goods Only private goods are included All private and public goods are included
International Trade No distinction between national or international goods Only national goods are summarised
Basket of goods Fixed composition Flexible composition
7
The Costs and the Origins of Inflation

• The costs of a correctly anticipated Inflation
• suboptimal store of money (cash without
  interest is shifted to Financial Intermediaries
  shoe leather costs)
• menu costs (change price lists and convert
  machines)
• cold progression in the tax system

8
The Costs and the Origins of Inflation

• The costs of an incorrectly anticipated
  Inflation
• profit income earners benefit more than wage
  earners,
• nominal income earners lose and
• debtors benefit at the expense of creditors.
• The results are high allocation costs and an
  arbitrary
• distribution of income and wealth.

9
The Costs and the Origins of Inflation

• Inflation could result from an activist economic
  policy.
• There are two types of Inflation
• Supply induced Demand induced
• Cost-push Inflation Demand-pull
  Inflation

10
Cost-push Inflation
Price level
Inflation is dueto accommodatingfiscal policy
Yn
Aggregate output
11
Demand-pull Inflation
Price level
Yt
Yn
Aggregate output
12
Another Reason for InflationGovernment budget
constraint

• To see how fiscal policy is related to monetary
  policy, we have to look at the governments
  budget constraint.
• DEF G - T ?MB ?B
• When the publics bond holdings do not increase,
  a given deficit will have to be financed by
  monetizing public debt.
• Financing a persistent deficit by money creation
  will lead to sustained inflation.

13
The Monetarist versus the Keynesian view

• The modern quantity theory of money (Milton
  Friedman) concludes that changes in aggregate
  spending are determined primarily by the money
  supply.
• Keynesian analysis indicates that high inflation
  cannot be driven by fiscal policy only.
• But both viewpoints tell us that high inflation
  can occur only with a high rate of money growth.

14
The Phillips-Curve and its Implications

• Inflation (?) and unemployment (u) both have a
  relative negative impact on the economy as a
  whole.
• In 1958 A. W. H. Phillips discovered a
  relationship between unemployment and Inflation.
  Phillips research was focused on the economic
  statistics between 1861 and 1957. He looked at
  the rate of change in ages, and the level of
  unemployment.
• He found a stable, inverse relationship between
  these two variables.

15
The Phillips-Curve and its Implications
The Phillips curve can be interpreted as a
trade-off To get reduced unemployment, the
economy must suffer from more Inflation, and to
get reduced Inflation, the economy must suffer
from more unemployment.
16
The Phillips-Curve in the USA for 1950-1960
8 7 6 5 4 3 2 1
Inflation
Phillips-Curve
2 3 4 5
6 7
Unemployment Rate in
Source Economic Report to the President, 1985
17
The Phillips-Curve in Germany
Phillips-Curve from 1961 to 1973
Unemployment Rate in
18
Expectations-augmented Phillips Curve

• Developed by Milton Friedman(1968) and Edmund
  Phelps (1967)

? ?e - ?(u - un) ?
Expected Inflation
Cyclial Unemployment
Supply Shock
19
expectations-augmented Phillips Curve in the
short and long run

• At a short notice Friedman and Phelps accepted
  a trade-off between Unemployment and Inflation.
• But in their view the Philips curve will be
  generated in a vertical line in the long run.
• Demand management is useless and leads only to
  Inflation (Deflation)

20
expectations-augmented Phillips Curve in the
short and long run
Long run Phillips-Curve
Short run Phillips-Curve with high inflation
expectation
21
Indexation An International Comparison

• Changes in price indices are sometimes used to
  adjust wage rates or transfer payments. This is
  called Indexation.
• Full Indexation occurs when the wages or
  payments are increased at the same rate as the
  price index used to measure the inflation rate.
• Indexation is especially widespread in
  developing countries with high inflation rates.

22
Indexation An International Comparison

• Keeping up with inflation real income stays
  constant.
• an arbitrary distribution of income and wealth.
• Elimination of Inflation Costs in the field of
  national savings and wages.

Indexation Are you beating inflation or is
inflation beating you?
23
Indexation An International Comparison

• The Business Rates in England
• Scala mobile in Italy
• The Prohibition of Indexation in Germany

24
The Business Rates in England

• Vertical grants are the most important financial
  source of the local authorities in England.
• The Council Tax and the Business Rates amount
  only to one third.

25
The Business Rates in England

• The Business Rates replaced the Domestic Rates on
  1st April 1990.
• The complete tax revenues belong to the local
  authorities, but the respective yield of the
  municipalities is not dependent on the collected
  tax. In fact all cities and municipalities
  assign the collected tax to a fund of the
  central government. The central government
  distributes the revenues with a local
  equalisation system - mostly based on the number
  of inhabitants back to the local authorities.
• Re-Distributed Business Rates

26
The Business Rates in England

• The Business Rates tax only Non-Domestic
  Property.
• Two factors determine the tax burden of the
  Business Rates
• The Rateable Value of the property, which is
  fixed by the Valuation Office Agency (VOA).
• The Multiplier, which is fixed annually by the
  central government.
• Example A Rateable Value of 10,000 , in the tax
  year 2001-2002 the Multiplier amounted to 43
  Pence 4,300 tax burden.

27
The Business Rates in England

• The political task of the Multiplier is to
  minimize the tax burden for the population
  (voters) and on the other side to generate a
  constant tax yield for the local authorities.
• The Multiplier is is fixed annually by the
  central government, but it is forbidden by law to
  raise the Multiplier to a higher figure than the
  inflation rate.
• An Indexation, but not a full indexation

28
Scala mobile in Italy

• In Italy the relationship between employer and
  trade unions was extremely tense.
• Therefore from 1946 until 1992 the wages
  increased at the same rate as the price index.
• scala mobile
• In the majority of the years a Full Indexation
• In 1992 the scala mobile were repealed
• 1993 Ciampi protocol
• 1996 Accordo per il Lavoro

29
The Prohibition of Indexation in Germany

• In 1948 every form of Indexation was abolished in
  Germany.
• confidence-building measure
• It was only allowed by permission of the
  Bundesbank to index some price levels. These
  permissions were rare.
• Because of the introduction of the , the
  abolishment of the indexation of loans was
  cancelled in 1999.

30
The Prohibition of Indexation in Germany

• Today the indexation of wages, leasing and fees
  is still forbidden.
• The central government has heralded an
  inflation-indexed bond with a volume of 10
  billion for the year of 2005.
• Nowadays more than 26 countries worldwide offer
  an inflation-indexed bond.

31
Conclusion

• Inflation is a sustained increase in the general
  level of prices for goods and services.
• Variations on inflation include deflation,
  hyperinflation and stagflation.
• Two theories as to the cause of inflation are
  demand-pull inflation and cost-push inflation.
• No inflation (or deflation) is not necessarily a
  good thing.